TCO 7 Given the assets and liabilities of a bank and the required reserve ratio, calculate the maximum potential of the banking system to create deposits,

TCO 7Given the assets and liabilities of a bank and the

required reserve ratio, calculate the maximum potential of the banking system to create deposits, assuming no leakages from the banking system.

1.Explain the use of M1 and M2 to measure the supply of money.

2.Use actual figures of the money supply to illustrate the overwhelming importance of bank deposits in the money supply.

3.Explain the process of multiple deposit creation.

The Four Jobs of Money

• Medium of exchange• Standard of value• Store of value• Standard of deferred payment

Medium of Exchange

• The most important job of money is to serve as a medium of exchange– When any good or service is purchased, people

use money– Money makes it easier to buy and sell because

money is universally accepted– Money, then, provides us with a shortcut in

doing business• By acting as a medium of exchange, money

performs its most important function

Standard of Value

• Money is a common denominator in which the relative value of goods and services can be expressed– A job that pays $2 an hour would be nearly

impossible to fill, while one paying $50 an hour would be swamped with applications

– Does money work well as a standard of value? You tell me

Store of Value• If you could buy 100 units of goods and services

with $100 in 1983, how many units could you buy with $100 in 2003?– Answer: you could have bought just 51 units

– During this period, inflation robbed the dollar of almost half of its purchasing power

• Over the long run, particularly since World War II, money has been a very poor store of value– However, over relatively short periods of time, say,

a few weeks or months, money does not lose much of its value

Standard of Deferred Payment

• Many contracts promise to pay fixed sums of money well into the future– A couple of examples are 30-year corporate

bonds and a 20-year mortgage

Standard of Deferred Payment

• When Dave Winfield signed a 10-year, $23 million contract with the New York Yankees in 1980, he really got stuck– Because over the next 10 years the consumer

price index went up by almost 59 percent– Today when a professional ballplayer,

entertainer, or virtually anyone else signs a long-term contract, she or he is generally protected by an escalator clause, which calls for increased payments to compensate for any future inflation

Money versus Barter

• Without money, the only way to do business is by bartering

• For barter to work, I must want what you have and you must want what I have– This makes it pretty difficult to do

business• “Everything, then, must be assessed in

money: for this enables men always to exchange their services, and so makes society possible”– Aristotle, Nicomachean Ethics

Our Money Supply

• Money consist of coins, paper money, demand (or checking) deposits, and checklike deposits (commonly called NOW – or negotiable order of withdrawal – accounts) held by the nonbank public– Coins and paper money together are

considered currency– Five of every ten dollars in our money supply

are demand deposits and other checkable deposits

• Virtually all the rest is currency – Checks are notnot money, demand (or checking

deposits) are money

Our Money Supply

M1, M2, and M3

Currency

+ Demand deposits

+ Other checkable deposits

+ Traveler’s checks

= M1 (traditionally our basic money supply)

Our Money Supply

M1, M2, and M3

Currency

+ Demand deposits

+ Other checkable deposits

+ Traveler’s checks

= M1

+ Savings deposits

+ Small-denomination time deposits (less than $100,00)

+ Money market mutual funds held by individuals

= M2

Our Money Supply

M1, M2, and M3 Currency

+ Demand deposits

+ Other checkable deposits

+ Traveler’s checks

= M1

+ Savings deposits

+ Small-denomination time deposits (less than $100,00)

+ Money market mutual funds held by individuals

= M2

+ Large denomination time deposits (more than $100,00)

+ Money market mutual funds held by institutions

+ Other less liquid assets

= M3

The Demand for Money

• The amount of money people hold is called money balances

• John Maynard Keynes noted that people had three reasons for holding money– People hold money to make transactions– People hold money for precautionary reasons– People hold money to speculate

• Economists have since identified four factors that influence the three Keynesian motives for holding money– The price level– Income– The interest rate– Credit availability

The Keynesian Motives for Holding Money

• The transaction motive– Individuals have day-to-day purchases for

which they pay in cash or by check– Individuals take care of their rent or mortgage

payment, car payment, monthly bills, and major purchases by check

– Businesses need substantial checking accounts to pay their bills and meet their payrolls

The Keynesian Motives for Holding Money

• The precautionary motive– People will keep money on hand just in case

some unforeseen emergency arises• They do not actually expect to spend this

money, but they want to be ready if the need arises

The Keynesian Motives for Holding Money

• The speculative motive– When interest rates are very low you don’t

stand to lose much holding your assets in the form of money

– Alternatively, by tying up your assets in the form of bonds, you actually stand to lose money should interest rates rise

• You would be locked into very low rates– This motive is based on the belief that better

opportunities for investment will come along and that, in particular, interest rates will rise

Four Influences on the Demand for Money

• The price level– As the price level rises, people need to hold

higher money balances to carry out day-to-day transactions

– As the price level rises, the purchasing power of the dollar declines, so the longer you hold money, the less that money is worth

– Even though people tend to cut down on their money balances during periods of inflation, as the price level rises people will hold larger money balances

Four Influences on the Demand for Money

• Income– The more you make, the more you spend– The more you spend, the more money you

need to hold as cash or in your checking account

– Therefore as income rises, so does the demand for money balances

Four Influences on the Demand for Money

• Interest rates– The quantity of money demanded (held) goes

down as interest rates rise• The alternative to holding your assets in the

form of money is to hold them in some type of interest- bearing paper

• As interest rates rise, these assets become more attractive than money balances

Four Influences on the Demand for Money

• Credit availability– If you can get credit, you don’t need to hold so

much money• The last three decades have seen a

veritable explosion in consumer credit in the form of credit cards and bank loans

• Over this period, increasing credit availability has been exerting a downward pressure on the demand for money

Four Influences on the Demand for Money

• Four generalizations– As interest rates rise, people tend to hold less

money– As the rate of inflation rises, people tend to

hold more money– As the level of income rises, people tend to

hold more money– As credit availability increases, people tend

to hold less money

The Demand Schedule for Money

The Three Demands for Money

Total Demand for Money

This is the sum of the transaction demand, precautionary demand, and speculative demand for money shown in the previous slide

Total Demand for Money and the Supply of Money

The interest rate of 7.2 percent is found at the intersection of the total demand for money and the supply of money (M)

Since at any given time the supply of money (M) is fixed it can be represented as a vertical line

Who Controls the Interest Rates?

• The people who borrow money– Players

• Banks– Referees

• The FED– Coach

Modern Banking• A bank is a financial institution that accepts

deposits, makes loans, and offers checking accounts– Banks keep about 2 percent of their deposits

in the form of vault cash– All the nation’s commercial banks, credit

unions, savings and loan associations, and mutual savings banks now have to keep up to 10 percent of their checking deposits on reserve

• This means “on the books”• Remember, checking deposits are

bookkeeping entries

Modern Banking

• Commercial Banks– Until the passage of the Depository

Institutions Deregulation and Monetary Control Act of 1980, only commercial banks were allowed to issue checking deposits

• They were the only institutions clearly recognized as banks

– Commercial banks account for the bulk of checkable deposits

– There are 8,000 commercial banks in the United States

Modern Banking

• Mutual Savings Banks– Mostly operated in the northeastern United

States, these institutions were created in the 19th century to encourage savings by the “common people”

– They traditionally made small personal loans, but today, like savings and loan associations, they offer the same range of services as commercial banks

– There are nearly 1,400 mutual savings banks

Modern Banking

• Savings and Loan Associations– Although originally established to finance

home building, these associations also offer most of the services offered by commercial banks

– The nearly 1,100 S&Ls invest more than three quarters of their savings deposits in home mortgages

Modern Banking

• Credit Unions– Although there are nearly 10,000 credit unions

in the United States, they hold less than 5 percent of total savings deposits

– Credit unions offer a full range of financial services

• They specialize in small consumer loans– Credit unions are cooperatives that generally

serve specific employee, union, or community groups

Modern Banking

• The Banking Act of 1980 blurred the distinction between commercial banks and the three other depository institutions– The main distinction – that before 1980 only

commercial banks were legally allowed to issue checking accounts – was swept away in 1980

Bank Lending

• Banks borrow money at low interest rates and lend money out at much higher interest rates– Currently, banks pay either zero or up to

maybe 3 percent interest on most deposits – and perhaps 1 or 2 points more if you leave your money on deposit for a few years

– Banks charge about 7 percent for fixed rate mortgages, a bit more for business loans, and about 18 percent on credit card loans

The Creation and Destruction of Money

• Banks create money by making loans– This money is created out of nothing– This money is new money in the form of

additional demand deposits• Money is destroyed when a loan is repaid

– When a loan is repaid, demand deposit accounts go down

– This money disappears back into nothing• The interest that was paid does not

disappear • The Federal Reserve can affect the bank’s ability

to create money by increasing or decreasing the bank’s reserve requirements

How money is created Step 1.

Bank of DeVry

Reserves = deposits = $1 million

Required Reserves = 10% or 1/10 = 100,000

Excess Reserves = 90% or 900,000 which are loaned out to earn income for the bank

How Money is Created Step 2.Bank of DeVry

I deposit $100,000 in the bank so deposits are now $1,100,000. The bank now has required reserves of 110,000 and excess of 90,000 which it can loan.

How Money is Created Step 3.Bank of DeVry

Bank loans out 90,000 to a person who buys a house. The seller of the house deposits the money if her bank, Bank of On-Campus

Bank of On-Campus

Bank of On-Campus now has new deposits of 90,000, new required reserves of 9,000 and excess reserves of 81,000 which it will loan out to someone else.

How much money COULD be created through all steps.

Bank of DeVry

Bank of On-Campus

Bank of next

Bank of next

Bank of next

Bank of next

Banks of etc.

The money multiplier in this case is 10. It is the reciprocal of the required reserve ratio [10% in this case]. To find the amount by which the banking system could increase the money supply, multiple the new deposit by the multiplier.